Tap foreign debt, but locally: govt

New Delhi: The government has, in principle, decided to auction the rights to raise money through external commercial borrowings (ECBs) and to simultaneously relax the current foreign investment cap of $15 billion (Rs66,600 crore) in rupee-denominated debt, according to a person familiar with the development who did not want to be named.

The decision, taken jointly by the Reserve Bank of India (RBI) and the ministry of finance (MoF) recently, will be operationalized after the due notifications are issued.

Once effected it will make ECBs less attractive to companies and, as a result, reduce the pressure on the central bank to sterilize excessive inflows of foreign currency to prevent the rupee appreciating. At the same time, the increase in ceiling on investment in rupee debt will ensure that fund flows to companies is not choked off as a result. At the same time the move shifts the onus of the currency risk to foreign institutional investors (FIIs) and also taps into the rising trend of investment in local currency debt.

In the past year, FIIs have demonstrated an incredible appetite for Indian corporate debt. According to data computed by the market regulator, Securities and Exchange Board of India, the cumulative investment in debt by FIIs (from 1992) aggregated $12.43 billion as on 21 April, while it was $5.17 billion just a year ago, indicating an increase of about $7 billion.

The RBI-MoF move is consistent with recent initiatives undertaken by the ministry with respect to ECBs. After the broad policy stance towards liberalization was retained for the first half of 2009-10, the two have begun a partial rollback beginning 1 January after the economy began to recover. In particular, RBI has reduced the interest rate spread, making it that much more difficult for corporates to raise easy money.

ECBs declined between April and December 2009 on account of the flux in international credit markets. Indian companies raised $2.29 billion in this period, 203% lower than the money raised during the corresponding period of the previous year. Overseas borrowing by Indian firms through ECBs peaked in 2007-08, when they borrowed $22.60 billion. Interestingly, the rupee had appreciated during that period too forcing MoF and RBI to tighten funds flow through various measures, including restricting ECBs.

“Auctioning is a good way, the most optimum way today. Proceeds of auctioning can be used to mitigate sterilization costs. Large companies are the ones that use ECBs. It is fair that they pay for it,” said A.V. Rajwade, a consultant who was a member of RBI’s committee on capital account convertibility. The Economic Times had reported on 3 April that the government was considering auctioning ECB entitlements given the growing pressure on the rupee on account of enhanced capital inflows.

Significantly, the growing interest rate differentials between the US, Europe and emerging markets, including India, that have seen a faster economic recovery, are resulting in large fund flows into debt instruments. The Indian currency has appreciated by around 12% in the past year, making returns on rupee denominated debt that much more attractive.

RBI and MoF also propose to relax the present cap of $15 billion on FII investment in corporate debt. The person familiar with the matter declined to disclose the new ceiling.

According to EPFR Global data, emerging markets bond funds set an all-time weekly inflow record in the week ended 14 April, taking in $1.8 billion of new money from investors, and with $10.4 billion of year to date inflows have now surpassed the previous full-year inflow record set in 2005.

“Flows into emerging markets bond funds with a local currency bond mandate accounted for over 50% of the total flows into this fund group. EM Blend Bond Funds, which contain at least a 25% allocation to local currency bonds, also had their best week on record,” the EPFR report added.

This is consistent with the Indian experience in the last fiscal. According to the latest data compiled by RBI, the aggregate capital inflows in 2009-10 (April-December) was $43.2 billion, about eight times more than the $5.8 billion in the corresponding period of the previous year. The surge in inflows in 2009-10 was largely on account of $20.5 brought in FIIs, which had net withdrawals of $12.4 billion in the corresponding period of the previous year.

The increased inflows have put pressure on the rupee to appreciate.

“Exchange rate is the most important price in a globalized emerging economy. It affects costs and yields on too many transactions. Liberal capital inflows benefit the financial economy, but can be disastrous for the real economy because of the rupee’s appreciation,” Rajwade added.